No-Arbitrage Approach to Pricing Credit Spread Derivatives

Are Credit Spreads and Interest Rates Co-Integrated? Empirical Analysis in the USD Corporate Bond Market

The study conducts an empirical test on dollar-denominated sovereign credit spreads in emerging markets, including Brazil, Colombia, Mexico, the Philippines, the Russian Federation, and Turkey to examine their relationship with each country’s exchange rate and the United States (US) Treasury yields. The relationship between each country’s exchange rate and the pricing of each country’s US-dollar denominated sovereign bonds was particularly strong after the global financial crisis of 2008–2009. A two-factor pricing model is developed with closed-form solutions for the sovereign bonds. The correlated factors in the model are foreign exchange rates and US risk-free interest rates that follow a double square-root process relevant in a low interest rate environment. The numerical results and associated error analysis show that the model credit spreads can broadly track market credit spreads.

In this paper, we have developed a pricing model for credit spread options with the existence of the counterparty default risk. The default dependence is modeled in the interacting intensities framework, and the correlation between default and the interest rate is considered. Semi-analytic pricing formulas for European credit spread put options with counterparty risk are derived. The numerical analysis shows that the counterparty default risk has a considerable influence on the value of a credit spread option.

Classic options can no longer meet the diversified needs of investors; thus, it is of great significance to construct and price new options for enriching the financial market. This paper proposes a new option pricing model that integrates the logarithmic investment strategy with the classic Black–Scholes theory. Specifically, this paper focus on put options, introducing a threshold-based strategy whereby investors sell stocks when prices fall to a certain value. This approach mitigates losses from adverse price movements, enhancing risk management capabilities. After deriving an analytical solution, we utilized mathematical software to visualize the factors influencing new option prices in three-dimensional space. The findings suggest that the pricing of these new options is influenced not only by standard factors such as the underlying asset price, volatility, risk-free rate of interest, and time to expiration, but also by investment strategy parameters such as the investment strategy index, investment sensitivity, and holding ratios. Most importantly, the pricing of new put options is generally lower than that of classic options, with numerical simulations demonstrating that under optimal parameters the new options can achieve similar hedging effectiveness at approximately three-quarters the cost of standard options. These findings highlight the potential of logarithmic investment strategies as effective tools for risk management in volatile markets. To validate our theoretical model, numerical simulations using data from Shanghai 50 ETF options were used to confirm its accuracy, aligning well with theoretical predictions. The new option model proposed in this paper contributes to enhancing the efficiency of resource allocation in capital markets at a macro level, while at a micro level, it helps investors to apply investment strategies more flexibly and reduce decision-making errors.

We present a pricing kernel that summarizes well the main features of the dynamics of interest rates and risk in postwar U.S. data and use it to uncover how the pricing kernel has moved with the short rate in this data. Our findings imply that standard monetary models miss an essential link between the central bank instrument and the economic activity that monetary policy is intended to affect, and thus we call for a new approach to monetary policy analysis. We sketch a new approach using an economic model based on our pricing kernel. The model incorporates the key relationships between policy and risk movements in an unconventional way: the central bank's policy changes are viewed as primarily intended to compensate for exogenous business cycle fluctuations in risk that threaten to push inflation off target. This model, while an improvement on standard models, is considered just a starting point for their revision. It leads to critical questions that researchers need to answer as they continue to revise their approach to monetary policy analysis. Copyright © 2009 by the National Bureau of Economic Research.

Recent events have highlighted the potential importance of nonlinear efiects of flscal variables (notably debt and deflcits) on interest rates: While in times when government solvency is not a concern the standard crowding-out efiects are of moderate magnitude, in times when default risk becomes an issue the interest rate efiects can become very large. This paper provides new evidence on the magnitude of these efiects. For the case when default risk is not a concern, it uses an arbitrage-free term structure model to estimate the dynamic efiects of flscal policy shocks on interest rates along the entire maturity spectrum. For the case when default risk becomes a concern (thereby violating a central assumption of the term structure model), I present evidence based on EMU government bond spread regressions on time-varying efiects of national flscal policies on spreads as well as the time-varying sensitivity of yield spreads to international risk aversion as a function of the state of flscal policy. JEL classiflcation: E6, H6.

In the following, we develop a model for pricing defaultable debt that is capable of reflecting real world phenomena realistically. Before we actually introduce the model, we make some heuristic observations to motivate the theory. Throughout the following sections we examine and extend these considerations further: Since defaults actually happen, a bond pricing model must be able to deal with default events: For example, in August 1999 Ecuador defaulted on interest rate payments of Brady bonds with a total amount of about US$ 6 billions. In October 1999 there was a second default of US$ 500 millions. Figure 6.1 shows the yields to maturity and S&P ratings of an Ecuadorian sovereign bond that was downgraded to the rating D in September 1999. Rating agencies can’t check the ratings on a daily basis or even continuously. Ratings of rating agencies can only be described by discrete time processes. But the quality of an obligor usually changes according to a continuous time process (see, e.g., figure 6.1). Thus, the quality or the distance to default of an obligor should be observed continuously. Very often the quality of obligors shows mean reversion properties. In case of a downgrade the management of a firm usually takes actions to improve the quality again. Figure 6.2 shows this phenomenon for the firm Hertz. The mean reversion level of the rating of Hertz is A- and A3 for S&P’s and Moody’s rating, respectively. Many models for pricing defaultable zero coupon bonds don’t allow for positive short term credit spreads: As time to maturity tends to zero the model credit spreads tend to zero, too. Obviously, these models are far away from describing reality. In figure 6.3 we show observed corporate credit spreads for different maturities. Even bonds with a rating of A and time to maturity of seven days can have credit spreads which are higher than 500 basis points. Hence, a model must be capable of generating high credit spreads even for short term debt. Yields and credit spreads usually depend on the quality of the obligor. The better the quality the smaller the yields (compare to figure 6.4). The time series of the yields show high correlations between the rating classes A and AAA. Gains and losses are — at least to some extend — caused by changes in the quality of the obligor. Credit spread processes often show mean reversion properties. See, e.g., figure 6.5. Non-defaultable interest rates are usually mean reverting. See, e.g., figure 6.6. KeywordsDefault RiskCredit SpreadBond PriceShort RateCredit DerivativeThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

Dynamics of Market Anomalies and Measurement Errors of Risk-Free Interest Rates

In this paper, we use Vasicek model to determine the pricing of corporate bonds under the risk-free interest rate, and adjust it through the credit spread to make it suitable for the pricing of corporate bonds with default risk. Furthermore, this paper tests the bond pricing model based on the bond data of three companies, and the results show that the model can well capture the bond price trend, but it is difficult to accurately capture the price fluctuation.

Financial Crisis, Equity Capital and the Liquidity Trap

By Force of Habit: A Consumption-Based Explanation of Plantation of Aggregate Stock Market Behavior

The “natural rate of interest” is the hypothetical, risk-free real rate of interest that would obtain in a closed economy, if net public debt were zero. It is considerably less than the optimal steady-state rate of interest, which is equal to the system’s growth rate. This holds for a very general “meta-model.” The fundamental equation of capital theory holds on the optimal steady-state path:T = Z − D, whereTis the overall economic period of production,Zis the representative private “waiting period” of consumers andDis the public debt ratio. Prosperity is at least 30% lower at the natural rate of interest than at the optimal rate.

Corporate yield spreads and real interest rates

Institutional Equity Investment, Asymmetric Information and Credit Spreads

Enhanced Corporate Bond Yield Modelling Incorporating Macroeconomic News Sentiment